Equities analysts at UBS have issued a research report on the merger between CME Group and NEX Group, stating that while they are confident in the potential upsides to this deal, the benefits might not start to materialise for at least a year.
Having previously downgraded CME shares from “Buy” to “Neutral”, the UBS analysts Alex Kramm and John Goode decided to maintain the current rating, with an unchanged 12–month price target of $204 per share. At the time the report was issued, CME shares were trading at $189.51.
Having met with CME’s global head of financial and OTC products, Sean Tully, to discuss the NEX transaction in greater detail following the close of the deal in November, the analysts say that they “walked away constructive on the opportunity set ahead as the company combines cash and futures markets”. But despite this, they noted that it “may take at least 12-18 months for any tangible revenue benefits to be realised” and cautioned that there may be some “near-term integration noise”.
As a result, Kramm and Goode think that CME’s share price will be driven by volume and volatility for now, with much of this already priced in.
“While we continue to believe that CME has a best-in-class model and is well positioned to benefit from cyclical/secular opportunities and the recent NEX transaction, we think this is already priced in, with shares trading above the high end of the historical range relative to the S&P 500 since 2010. While we think CME shares should trade as a premium to peers, the valuation appears somewhat stretched with the market already anticipating volume growth to exceed its post financial crisis CAGR,” conclude the analysts in the report.
Of particular interest in the report though, is the five areas where CME management highlighted synergies between the two companies: cross-selling initiatives, market access, post-trade efficiencies and data.
“While CME did not quantify these opportunities, or the timeline to achieve them, management was excited about the outlook ahead. In fact, when pressed on the number and size of opportunities, management suggests that it had outlined several distinct projects with revenue target ranges that should be meaningful even at the low end. Importantly, management noted that pricing would not be a major driver of achieving revenue synergies,” say Kramm and Goode in the report.
With CME now home to both the leading cash and futures markets for US interest rates and FX, the company apparently sees this as an opportunity to cross-sell via cross pollination and the increased utilisation of both cash and futures by each individual group of market participants. The analysts note, however, that CME management appear most excited about the possibilities for cross selling in FX.
Thereport points out that of the nearly $5 trillion per day traded in the OTC FX market, swaps account for nearly $2.4 trillion, and that while the CME launched its FX Link product, which is the economic equivalent of a swap, having cash and futures products under one roof could help it further penetrate this market.
In terms of cross-selling, the analysts also point out that EBS has good penetration with regional banks across Europe and Asia, something that CME Group – with less than 50 sales people in Europe – has traditionally lacked. As another statistical example of the different client groups these firms focus on, they point out that CME’s core client base includes the top 50 banks in the world, whereas NEX has penetration amongst the top 1,000.
“Given that these banks largely do not trade FX futures, CME sees it as an opportunity to cross-sell into the EBS base on the premise of increasing education on the cost savings of standardised, centrally cleared futures relative to the underlying OTC contracts (~75%). While the opportunity was not quantified, management clearly sees this as an on-ramp to a much deeper customer base with which it can encourage the increased use of futures,” observes the report.
It does note though that while this cross-selling might be the most near-term opportunity following the acquisition of NEX, it can still often take over a year from the first point of contact with the CME to the first trade being done by a new client due to the process of educating and onboarding them.
A key area of potential cost savings identified by CME is apparently in market access. NEX customers today might be connecting to as many as 10 different NEX-owned entities, but the report says that CME believes this can be streamlined down so that clients will be able to access NEX’s cash markets and CME’s futures and options through a single API. This will drive cost synergies for the Merc, because it will mean that it has to maintain fewer access points to the various platforms.
The story is similar with EBS, according to the report: “CME highlighted how EBS users have an existing machine and interface through which they access the platform. Management believes a natural opportunity is to simply integrate futures functionality into this desktop, which could in turn potentially spur increased activity as traders have both spot and futures at their fingertips.”
On the post-trade side, CME sees possible efficiencies by bringing together its clearinghouse and the NEX Optimisation business. The exchange group has already been using the multilateral compression service provided by NEX’s TriOptima business for several years, and the report says that CME thinks it can leverage this technology to improve its own multilateral compression service that it launched for equity index options on futures.
In addition, although when CME announced the NEX acquisition, it also confirmed that the Fixed Income Clearing Corp (FICC, part of DTCC) will remain the clearinghouse for cash Treasuries, the exchange group will now have the ability to view both client cash and futures positions US Treasuries.
As a result, Kramm and Goode say that the CME aims to find new ways to achieve better cross-margining efficiencies between DTCC and its own clearing house.
“CME and FICC already have cross-margining agreements in place, but they are not widely used and only available to banks. As CME gains a better understanding of customer positions across cash and futures, it could find ways to create new efficiencies not only with its bank end users, but potentially expand these to principal trading firms. This could help to further free up customer capital across a variety of clients, which could in turn drive more trading. On the flip side, this could also help prevent position concentration from a risk perspective,” they explain.
Data is the last area where CME has identified efficiencies from bringing the cash and futures markets together. Kramm and Goode say in the report that while other exchange groups have been ramping up their market data businesses in recent years, the CME’s has remained “relatively basic”.
“The data offering was always meant to support the priority of driving increased volumes. While the goal remains the same, management seemed to indicate an increased willingness to monetise its data, especially now that it is uniquely positioned to provide a single, comprehensive product covering both cash and futures for US rates and FX,” they add.
The UBS analysts say that CME also provided more colour on the expense synergies in the pipeline, although apparently the exchange maintains that investors remain more focused on revenue synergies. CME has previously said that it hopes to achieve $50 million of run-rate synergies by the end of 2019, $110 million by the end of the following year and $200 million by the close of 2021.
“These synergies generally fall under three main buckets, with a 16% headcount reduction spread amongst the buckets,” says the report.
The first bucket is selling, general and administration (SG&A) reductions, which apparently will account for 45% of the expected synergies. According to the UBS report, CME management emphasised the different organisational structure at NEX, which has division executives across its business lines, in contrast to the exchange which consolidates these functions to senior management. Because NEX consists of 10 different businesses, it has 10 different CFOs and many duplicative expenses which apparently “look to be low-hanging fruit in terms of cost reductions”.
IT and system migration and consolidation are due to account for 35% of the forecasted synergies, with much of these savings coming once all the NEX businesses are moved onto a single, unified platform with a universal client-facing interface. But Kramm and Goode point out, the complicated nature of migrating all of these systems means that the associated synergies will probably only be felt towards the end of the integration.
And finally, the consolidation of operational functions is expected to provide 20% of the expected synergies. This bucket is expected to consist of scale efficiencies as well as streamlining the operations supporting the various trading platforms and post-trade services. For example, as CME migrates the NEX platforms onto a single technology base, this will reduce the number of staff required to support the various technologies.